Manas Chakravarty: Goldilocks and the bears

Emerging markets have been basking in the warmth of an Indian summer

Last Tuesday, after the US Federal Reserve raised its Fed Funds rate by 25 basis points to 1.75 per cent, Bloomberg had two telling headlines. One of them said, "US stocks advance as Fed says US expansion is intact."

The other one was, "Dollar trades near one-month low versus euro in Asia after Fed statement". The second story went on to say that the dollar was weak because the Fed "refrained from improving its outlook for the economy".

In short, we had two markets with two very different interpretations of Fed Chairman Alan Greenspan's statement. And a couple of days after the rate rise, the yield on the 10-year treasury note in the US fell below 4 per cent, a sharp decline from the 4.9 per cent it had reached just three months ago.

The question is: why should the 10-year bond yield decline by around 90 basis points over a period when the Fed Funds rate has been hiked by 75 basis points?

Now consider the situation in India. In June, the Indian economy was riding high. After a GDP growth of 10.4 per cent in the fourth quarter of FY 2004, with forecasts of a good monsoon, and with subdued inflation, the outlook for growth never looked better.

Three months later, oil prices have risen, monsoons have been delayed, inflation has gone up sharply and bond yields have risen. Yet that didn't prevent the Sensex from hitting a 20-week high last Tuesday. The fact is, soft 10-year yields in the US and the bounce in the Indian market are inextricably connected.

The impact of dollar inflows
That link, of course, is through foreign institutional investor (FII) flows. The Securities and Exchange Board of India (Sebi) data shows that net FII inflows into equity have picked up and amounted to $252.9 million in the week to September 22.

And the money is pouring in not only to India, but to other emerging markets as well. As EmergingPortfolio.com points out, in the week to September 15, diversified Global Emerging Markets Funds enjoyed inflows for the first time since the week ending July 7, while Asia ex-Japan Equity Funds enjoyed their fourth straight week of inflows, receiving $528.7 million in the past four weeks.

The upshot: emerging markets across the world are booming. In the quarter to September 23, the MSCI Emerging Markets Free Index shows a rise of 6.37 per cent, compared to a decline of 2.07 per cent in the MSCI World Index.

The Emerging Markets Index is up 3.79 per cent for the year, compared to a rise of 1.35 per cent for the World Index. Is 2004 going to be a repeat of 2003?
 

MSCI Equity Indices Performance
	(Month to September 23)	Quarter to September 23	Year to September 23
World Index	0.931	(2.079)	1.356
USA	0.419	(2.796)	(0.614)
Emerging Markets	3.904	6.377	3.392
Emerging Markets Asia	3.987	4.463	(1.88)
China	6.958	7.777	(5.011)
India	6.044	13.783	(6.805)
Indonesia	8.397	12.842	25.897
Korea	3.208	3.24	(0.416)
Malaysia	3.288	3.757	5.858
Thailand	2.923	0.792	(11.838)
Taiwan	1.752	0.041	(4.15)

It's not only emerging equity markets that are on a roll. JP Morgan Chase's Emerging Markets Bond Index (EMBI) moved down from 304.5 as on March 31 this year, to 281.7 as on June 2, and it has since rebounded to 311.4 as on September 15. Emerging market bond funds had the sixth straight week of inflows in the week to September 15.

Rising dollar inflows have also resulted in the rise of the Asian currencies. Recently, the Singapore dollar was near a four-month high, the rupiah near a two-month high and the Indian rupee was at a 10-week closing high a few days ago.

2004 versus 1994
This is a situation different from the one prevailing at the end of May, when emerging markets fell precipitously on fears of rising interest rates in the US.

At that time, the worry was that the markets would do a repeat of 1994, when there was an across-the-board sell-off in emerging markets after the US Federal Reserve signalled an about-turn in monetary policy in March 1994. At that time, when the Fed switched to tightening mode, there was an immediate 10 per cent decline in the IFCI Emerging Markets Index.

In contrast, Fed tightening this year led to the MSCI Emerging Markets Free Index falling from 463 at the end of April, to 426 a month later, but it has since pulled back to 456 as on September 15, the bulk of that rise coming in the last month (the index was at 420 on August 4). Clearly, 2004 has not so far been a re-run of 1994.

The Bank of International Settlements tells the story succinctly, "There are at least two reasons for the markedly different behaviour of bond markets in 2004 compared to 1994. One is that the Federal Reserve now communicates more fully and widely about its intentions. ....Market participants were reassured by the likely "measured pace" of future rate rises indicated by the Fed starting with its statement of 30 June. A second reason is that the economic news released in the weeks following the June rate increase indicated a less robust economy than seemed the case following the 1994 increases. The US employment reports released in early July and August were both far weaker than expected, triggering a sharp fall in bond yields around the world."

And further, "In emerging debt markets, investors even turned bullish despite signs of global economic weakness. Most of the widening in emerging market spreads seen in April and May had reversed by August." Yet another reason for the boom in the Asian markets is continued growth in China, despite recurring fears of a slowdown. That is the reason why commodity prices have rebounded after they fell in May and June on worries of lower Chinese demand.

Many analysts now say that China's economy will grow 9 per cent this year. US bond markets don't seem to believe Greenspan's rhetoric about the prospects for US growth, and, therefore, doubt whether the interest rate tightening will continue.

Now that the monetary and fiscal stimulus has been removed, there's a big question mark over the US economy. The result is a reversion to conditions before the panic induced by Fed tightening, including the resumption of flows to emerging markets.

Liquidity
Liquidity continues to be abundant. In May, broad money growth was 5.5 per cent (y-o-y) in the US, 5.6 per cent in the euro area and 2 per cent in Japan.

For July, M3 growth was 4.8 per cent for the US and 5.5 per cent for the euro area, while Japan's broad money growth for August was 1.9 per cent. But in spite of the slight tightening, it hasn't affected liquidity.

That's because GDP growth has slowed substantially in the industrial world in the second quarter of 2004. For instance, GDP growth (in terms of percentage change on the previous quarter at an annual rate) in Q1 was 4.4 per cent in the US, 2.3 per cent in the euro area and 6.1 per cent in Japan. In Q2, these numbers were 2.8 per cent, 2.1 per cent and 1.3 per cent, respectively.

In other words, despite the tightening, lower growth has resulted in liquidity spilling over to asset classes such as bonds, emerging market debt and equities, and even commodities "" copper and aluminium were recently at five-month highs.

Goldilocks and emerging markets
The big question, of course, is whether this boomlet in the emerging markets is sustainable. The critical factor is what happens to US growth and inflation.

If growth is too high, oil and commodity prices will rise, inflation will shoot up, and the Fed will clamp down on money supply. That will be bearish for emerging markets. If growth is too slow, consumer confidence will plummet and demand will fall.

And since the US continues to be the main engine of global growth, exports across the world will falter, while money may be pulled out of equities.

That too will be bearish for emerging markets. In short, what emerging markets need is a not-too-hot, not-too-cold economy in the US. The economy has to be "just right", the way Goldilocks liked her porridge.

In short, for emerging markets to do well, the US economy must continue on its present path of slow growth and moderate inflationary expectations.

That's a tall order, with high oil prices on the one hand and a flagging economy on the other. Nevertheless, so long as Greenspan can keep Goldilocks out of the clutches of the bears, emerging markets can bask in the warmth of an Indian summer.